How Legal Shocks Could Still Send Bank Stocks Plummeting in 2014

NEW YORK (TheStreet) -- Bank stocks have proven remarkably resilient to a surge in litigation costs in 2013, so what would it take to rattle them in 2014?

The answer is a lot -- probably more than $100 billion -- but breaching that seemingly outsized number could be easier than many investors realize.

At least two large analyst reports have come out in the past month arguing that banks are likely to face many tens of billions more in legal costs tied to subprime mortgages.

On Tuesday, UBS analysts argued U.S. and European investment banks could face another $50 billion-$70 billion in legal costs tied to mortgage issues. They contended the market was mostly prepared for such an event, but not entirely so.

In a Nov. 25 report, Standard & Poor's credit analysts put the remaining costs much higher  -- at $55 billion-$100 billion just for the largest six U.S.-based banks -- a group that included JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), U.S. Bancorp (USB) and PNC Financial Services (PNC) but excluded Goldman Sachs (GS)and Morgan Stanley (MS). 

What is impressive about these reports is what they discount, which is virtually all other litigation risk away from mortgages. That is a big assumption to make, considering that banks still face a host of other regulatory and class action risk for issues including fixing of LIBOR and foreign exchange rates, anti-competitive practices tied to credit default swaps and allegations of power market manipulation.

This list is far from exhaustive. JPMorgan, for example, is expected to pay up to $2 billion to settle allegations it turned a blind eye to Bernard Madoff's Ponzi scheme. Still, it seems to capture most, if not all, of the well-known legal risks to the industry at this point.

But S&P's analysts dispense with these risks in a two-sentence paragraph. After listing the risks, they write:

"It is very difficult to ascertain and quantify what the exposures might be, if any, for some of the largest banks, but we anticipate that the size of any resulting settlements would be minor when compared with those related to mortgage issues."

UBS's analysts pick what they believe is the most serious of these non-mortgage issues -- LIBOR fixing -- and devote eight pages of their 33-page report to explaining why they don't believe investors should be overly concerned about the issue and why it is so difficult to estimate. Finally -- on page 21 of the report -- they cough up a number for the first time: $17.5 billion. They refer to this $17.5 billion as a "framework for estimating" the litigation risk, which appears to be an attempt to say it is even less certain than an estimate. That is presumably why they don't highlight the number earlier in the report as they did when estimating $55 billion-to-$70 billion in mortgage-related risk.

What they state higher up in the report, on a couple of occasions using slightly different wording, is this:

"At this point, we think the number of unknown variables makes it impossible to accurately quantify the class action litigation risk related to LIBOR -- if indeed there is any."

At the very least, regulators would appear to have left a healthy trail of breadcrumbs for class action plaintiffs.

Barclays (BCS), ICAP, Rabobank, Royal Bank of Scotland Group (RBS), and UBS (UBS) have already paid out a total of $3.7 billion in fines for allegedly distorting benchmark rates, the UBS report notes. The European Commission continues to investigate Credit Agricole, HSBC and JPMorgan regarding Euro interest rate derivatives and ICAP over Yen interest rate derivatives, according to UBS.

Deutsche Bank (DB), Societe Generale, RBS, JPMorgan and Citigroup have between them paid out another $2.3 billion in fines tied to anti-competitive behavior, with Barclays, UBS and Citigroup receiving immunities and lighter fines in some cases for cooperating with authorities.

And the numbers the UBS report throws around -- $120 trillion of derivatives and $35 trillion of securities -- before the analysts start narrowing things down would appear to leave quite a bit of margin for error.

The analysts are right: estimating the potential damage from LIBOR and these other non-mortgage issues is essentially impossible. But if the market is following their lead in discounting that damage from stock prices, it suggests some unwelcome surprises could certainly be in store for 2014.

-- Written by Dan Freed in New York

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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